Trouble with Foreclosures Intensifies: "Where Were all The Lawyers?"

For some time, there have been signs of trouble with real estate foreclosures because issuers of securitizations apparently failed to assure that loans could be foreclosed upon in the event of default on the underlying mortgage debt. So, for example, in Cleveland, in 2007, a judge dismissed a number of foreclosure actions brought by Duetsche Bank because the bank's ownership of the mortgage documents had vaporized and could not be proved in court.

I am frankly amazed that these problems have emerged because it seems to me that the lawyers representing the issuers of these securitizations owed professional obligations to undertake due diligence. This due diligence would require, at a minimum, to see to it that the notes and mortgages being pooled were valid under state law; that the mortgage was perfected, recorded and could be enforced through foreclosure in the event of default; and, that the foreclosure proceedings would not entail excessive cost. These mortgage interests in real estate then must have been transferred to investment vehicles in writing, in accordance with the Statute of Frauds, and through a recorded transfer that would preserve priority against subsequent transferees. A lawyer cannot be willfully blind to a client's reckless misrepresentations and must exercise due diligence to avoid participating in a fraud. Thus, a mortgage securitization must include enforceable mortgages. This entire process would then be preserved through the retention of appropriate documentation.

So, in 2007, when these issues first appeared, I was certain that they must be the result of isolated aberrations. In fact, the recklessness (or worse) of the private label securitizers now appears to be systemic and has triggered a coast-to-coast investigation of foreclosures by all 50 state attorney generals. There are three major problems.

First, there is certainly a procedural problem spawned by so-called robo-signers who were used to short-cut court procedures by signing affidavits in support of foreclosure actions without any factual basis or investigation. Some robo-signers executed 6000 affidavits in support of foreclosure per week. This systemic effort for cheap foreclosures simply reiterates the fundamental recklessness of the financial sector. This is fundamentally fraudulent. By raising the costs of foreclosure, here it appears that the state attorney generals seek massive loan write-downs, meaning massive loan losses to banks.

Second, many key loan and mortgage documents were not recorded in a proper way and instead used a nominee of dubious legal standing--in particular an outfit called MERS. This means of tracking mortgages seems to be a colossal failure because the courts are increasingly refusing to enforce mortgages held in nominee names. Consequently, there is some chance that a significant portion of the 64 million mortgages held in the name of MERS will be unenforceable leading to massive financial losses. Professor Chris Peterson suggests that MERS grew from hubris that exalted short tern profits over long term legal risks.

Third, it appears that many mortgage documents simply cannot be located. This one really baffles me. According to Professor Katherine Porter this is very common. Basically it appears that investors were induced to buy mortgage pools without enforceable mortgages. This will spawn years of litigation and accompanying losses for the financial sector. And, it is likely to require massive loan write-downs as banks renegotiate loans in the shadow of missing documents.

One financial expert calls this "the biggest fraud in the history of capital markets." According to Professor Georgette Phillips of the Wharton School of Finance: "This entire debacle is a symptom of the Wild West, shoot first and ask questions later, attitude of the securitization industry." My friend Christian Johnson puts it more succinctly: "This is all unbelievably bad."

Where does this all lead? Undeniably, this will mean a major loss of bank capital in a context where both the banking sector and the economy generally are already vulnerable, as Nouriel Roubini (48 minute mark) and Chris Whalen (1:07) make clear in this video. Moreover, this will hardly help the residential real estate market recover. So this will likely extend our economic problems, at best, and has the potential to trigger a major financial crisis, at worst.

The magnitude of the problem is betrayed by the banks' resort to congressional fixes. President Obama just vetoed legislation that would have eased many of the banks' documentation problems. The banks would not have sought such legislation unless they needed it to resolve a serious problem. Only the banks know the magnitude of this problem with certainty, but there is simply no doubt that is is now a major economic problem.

For me, however, the question is: where were all the lawyers when these securitization deals came down?